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Economic Update Fall 2023
The U.S. economy is currently in an elongated late cycle and could be at risk a deeper slowdown due to Federal Reserve’s hawkish stance on keeping rates higher for longer even as the lag effects of monetary policy are beginning to weigh on the economy. A year ago, many economists thought the U.S economy would be in a recession by now. However, Government spending and borrowing has kept the economy stronger and escaping a recession even in the face of rising rates so far. Furthermore, businesses and households came into this tightening cycle with healthy financials and savings that have allowed them to spend more. Most importantly, employment has remained resiliently low with workers’ wages rising supporting consumption.
Real gross domestic product (GDP) increased at an annual rate of 2.1% in the second quarter according to the Bureau of Economic Analysis. The Moody’s Analytics high-frequency real Gross Domestic Product (GDP) estimate for the third quarter fell from 4.2% to a still-strong 3.7% annualized. Yet there are parts of the US economy that are slowing. The Conference Board reported that the US Leading Economic Index trended lower last August for eighteen consecutive months indicating weakening conditions. The ISM Manufacturing Index is still in recession territory and the ISM Non-Manufacturing Index (services) remains in expansion reading. The services sector is keeping the US economy from a recession. The Federal Reserve lowered its U.S. economic growth from 1.9% to 1.7% for 2024. CNBC/Moodys analytics projects 1.3% GDP for 2024.
The September’ employment report is shocking in that it continues to prove every economist wrong. In fact, everyone has been wrong to be fair about the resiliency of the labor market. Payrolls increased twice as much as expected despite the growing number of strikes. Fiscal stimulus is in full gear creating jobs. Over 100,000 constructions jobs were added to the payroll recently. A strong labor market implies a recession is not happening soon until the labor market cracks. The unemployment rate is now 3.8% below the natural employment rate, which is the rate of normal unemployment in the US economy. Obviously, there is a structural shortage of laborers in the U.S. The Labor Department’s most recent initial jobless claims report shows the labor market is resilient despite tighter financial conditions. Initial job claims are surprisingly low at this point in the cycle given the fastest tightening cycle in history. Initial jobless claims have risen 4.6% from an extremely low level and remain relatively subdued. Continuing claims once again refuse to move higher. The latest continuing claims reported the lowest volume of new unemployment claims since January. Continuing claims are higher YOY by 28% but coming off an ultra-low level.
A gradual cooling in the labor market will allow the Fed a reason to stop hiking rates. The Fed projects unemployment to rise from 3.8% to 4.4% in 2024 which is way below unemployment associated with a recession. The Fed may cut rates by mid next year because the Fed’s measure of inflation, PCE inflation, is expected to be moving closer to its target for 2024 of 2.3%, and the economy should have been softened enough by the “higher for longer” policy. The odds of a Federal Reserve forecast for one more hike in rates this year are declining fast. The rise in bond market yields is doing the tightening for the Fed therefore no more hikes are needed with the Federal Funds rate sitting at its highest level in some 22 years. Tighter credit conditions are a headwind for consumers and inflation.
So far, the consumer has not been as sensitive to higher rates as in past tightening cycles and remains in good shape. Relatively low unemployment props up spending. Moreover, the consumer balance sheet has improved significantly since January 2020 having a positive effect on household wealth. Household debt was only 9.8% of disposable income, as of June, an historically lower figure, A preponderance of mortgage debt is also fixed at ultra-low rates well below the 7.74% historical average reported by Freddie Mac since 1971. The debt service ratio remains historically low based on data from FRED. The consumer has disposable income to spend. Supported by a strong labor market, resilient consumer spending could keep the US economy from a recession. Consumer spending is also being supported by Fiscal stimulus programs. The Federal Government is deficit spending by almost $2 trillion annually. Federal debt to Gross Domestic Product (GDP) is greater than one hundred percent of GDP. Government borrowing and spending from COVID stimulus programs have boosted consumer spending and kept the labor markets tighter than normal under monetary tightening regimes like the current one.
On the other hand, consumer spending has headwinds. COVID stimulus programs are ending, COVID savings have been spent down, and higher for longer rates should have a negative impact on the housing industry, retail industry, Bank lending, as well as consumer spending (70% of the US economy). For example, the housing sector activity, a major part of the US economy, is beginning to slow as the average rate on the popular 30-year fixed mortgage rose to 7.89%, according to Mortgage News Daily. Mortgage demand has slumped to a 1997 level. Bank of America reports that consumer credit debt has risen to $1 trillion at borrowing rates of 20% plus, mortgage refinancing cycle will be much costlier for homeowners. What else? Student debt repayment, higher energy prices and so on. I expect consumer demand and borrowing to decrease next year. Strikes are becoming more ubiquitous across industries such as writers, actors, auto workers, healthcare, airlines, and package deliveries. Strikes are a negative catalyst for consumer spending.
Inflation is way off its peak as the Consumer Price Index CPI has fallen substantially. CPI, which measures costs across a broad array of goods and services was up 3.7% from a year ago, according to the Labor Department. The Fed thinks core inflation is a better indicator of current inflation because it excludes volatile energy and food prices. Core CPI is up 4.3% year-over -year. More recently and important, Core inflation is down to 2.4% annualized on a CPI basis over the last three months with rent decelerating less but still slowing sharply. Factors that contribute to inflation are waning. The average hourly earnings rose 4.2% from a year ago, showing signs of cooling down from its peak of 6% in 2021. Broadly decreasing wage pressure with exception of UAW strikes, is another sign that inflation pressures are easing. Lower inflation is the solution to most issues weighing on current stock and bond market prices.
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